Is There a 'Moral Hazard' on Pay-Option ARMs?

If you attended the recent Senate Banking Committee hearing on "alternative mortgage products" you might've come away thinking that the payment-option ARM is the worst loan ever created by the mortgage industry. You also might've walked away thinking that POAs are ticking time bombs, waiting to explode inside each servicer's portfolio.

And if you're a mortgage professional, by now, you're sick and tired of all the misreporting on POAs that have been occurring in the general media and some of the trade press. In short, the POA has been so demonized it's a wonder any consumer would even consider one anymore.

So let's ask the basic question. Why would any consumer in his/her right mind take out a POA, make the minimum payment each month, increasing their overall loan balance? The simple answer is that such a mortgagor is on a tight budget and is trying to spend as little cash as possible. It also could be that such a customer is a spend thrift, can't stick to a household budget (if they even have one), and every month when the mortgage and credit card bills arrive they swallow lightly, and make the lowest payment possible, because darn it, they'll cry tomorrow.

But keep in mind a few things. POAs have been around for quite some time. World Savings (recently bought by Wachovia) has been making the loan for two decades. World is managed by Herb and Marion Sandler, two tight-fisted and fiscally conservative managers who, when it comes to risk taking, make Warren Buffet look like Paris Hilton. World Savings has never had a problem with the loan.

One item revealed in the Senate hearing that received little news coverage (except from National Mortgage News) was the fact that POAs are not currently suffering high delinquencies, at least not any higher than the going rate. Then again, the use of POAs didn't take off until early 2005, just when they U.S. housing market was peaking.

According to figures compiled by the Alternative Products Quarter Data Report (an affiliate of this periodical), POAs accounted for about 9% of industrywide production in the second quarter, or $83 billion out of an $877 billion market. Interest-only loans, the other "controversial" product out there, account for 20% of the market.

It's been suggested that rapidly rising home prices in red-hot markets can be tracked directly to POAs and IOs. The thinking is that the consumer figures out how little they can pay using these loans, and bids up the price against others who might have "conventional" financing.

If I was a consumer looking to buy into a hot neighborhood (and stay there), I would not use a POA and make the minimum payment each month unless I were a salesman or some type of entrepreneur who runs into money at "bonus" or year-end sales time. It's been said that in the "old days" these were the type of people using the loan, playing catch-up when the bonus money came in.

Any consumer using a POA today who is praying that more money will arrive in the mail unexpectedly from a dead uncle is out of their mind. It's just plain old stupid, but let's face it, compared to our peers in the rest of the world, Americans are spendthrifts. We like to buy big SUVs, big houses and big HDTVs. It is our birthright. (Plus, we have more space, unlike our cramped friends in Europe and Japan.)

But I will say this: any mortgage banker (or Realtor) pushing a POA as a way to qualify a borderline borrower should know better. Yes, there's a moral hazard here. Do not push loans on people if that person looks like they might have trouble making the payment down the road. It's bad business. It also could turn into a "loan buyback." I'm sure you've heard of those.

Now, with all that said, is the POA really an awful loan? It's not. It's a bit like medicine. Use just enough - and use it the right way - and it's wonderful. But take too much of it and it can kill you. That goes for lenders and consumers alike. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com